Proposed reforms to the Australian superannuation system (collectively known as “Stronger Super”) that impact superannuation trustees of registered superannuation entities (known as “RSE licencees” (“trustees”)) may also have important impacts for sponsors of private equity and hedge funds (“sponsors”).
What are the top three issues?
The top three issues for sponsors of private equity and hedge funds coming out of the Stronger Super regime are:
- disclosure proposals;
- draft APRA Prudential Standards on outsourcing and investments; and
- performance fees.
Disclosure of assets and valuations
Private equity and hedge fund sponsors are a secretive bunch. They have a focus on confidentiality, and hence there is limited transparency and disclosure of fund holdings and sponsor activities. In contrast, the Stronger Super regime aims to increase transparency in a range of ways.
Underlying portfolio holdings
Stronger Super will oblige trustees to report underlying portfolio holdings (including portfolio holdings underlying intermediate investment vehicles – such as private equity and hedge funds).
Twice a year, trustees will have to publish on their website:
- information that is sufficient to identify each of the financial products or other property in which assets, or assets derived from assets, of the fund are invested, as at the end of the reporting day; and
- the value of the assets, or assets derived from assets, of the fund, as at the end of the reporting day, that are invested in each of the financial products or other property.1
Stronger Super includes trace-through provisions that put obligations on intermediate holding vehicles and custodians. These provisions are intended to result in the same disclosure outcome where the ultimate source of an investment is from a trustee, regardless of whether investment is made directly or through intermediate holding structures
If the proposals become law then:
- when a trustee (or intermediate vehicle) makes an investment in a private equity or hedge fund, the sponsor must be notified that assets of a superannuation fund are being invested; and
- the sponsor will have an obligation to provide information to the investing entity (which may be a trustee or intermediate vehicle) sufficient for the underlying trustee to meet their publication obligations.
- A failure by the sponsor to comply may lead to an offence by the sponsor. If the information supplied by the sponsor is misleading or deceptive, or there is an omission of required information, the sponsor may commit an offence.
Disclosure of outsourced service providers
The supporting material for the most recent Stronger Super bill indicates that future regulations will require trustees to publish the names of all outsourced service providers.2 As trustees will be obliged to reveal this information to APRA after 1 July 2013,3 this additional disclosure obligation should not create a significant burden for trustees. Of course, publication may not be welcomed by sponsors.
Sponsors will need to determine whether they are prepared for increased disclosure by trustees of fund investments, sponsor identity and underlying holdings. For some sponsors, public disclosure of asset holdings or sponsor identity might be a bridge too far. In response to these changes, sponsors may exclude investments that include Australian superannuation money and hence limit the ability of Australian superannuation assets to be invested directly or indirectly in hedge funds and private equity funds.
The appointment of an investment manager is generally recognised to be a material business outsourcing by the trustee of a superannuation fund.
Are sponsors investment managers?
In this article we assume for the purposes of our exercise in discussing outsourcing and performance fees that a general partner, manager or sponsor is an “investment manager”. We do this because even if sponsors are not investment managers, trustees might proceed on that assumption. There are a number of reasons why a trustee might do that, including:
- to avoid the mere possibility of committing an offence; and
- because it wants to assess all investments on the same basis.
An “investment manager” is defined in the Superannuation Industry (Supervision) Act 1993 (“SIS Act”) as being “a person appointed by a trustee of a fund or trust … to invest on behalf of the trustee …”.4 Is the general partner, manager or sponsor of a private equity fund an investment manager for the purposes of the SIS Act? There is no Australian judicial authority on the point and no published guidance from APRA.
In any case, sponsors are likely to be considered investment managers for any co-investments made by a trustee with a sponsor outside a fund.
What would the outsourcing standards require if sponsors are investment managers?
Well, if the private equity fund or hedge fund is offshore, it would mean consultation with APRA.
Following its circulation of a discussion paper last September, APRA released a draft prudential standard governing outsourcing in April (the Draft Standard) to be issued under its proposed new powers over trustees.5
The Draft Standard sets out a number of requirements. Where a trustee contemplates a material business outsourcing, the trustee must:
- create outsourcing policy – the trustee must create an outsourcing policy, containing specific requirements its service providers must meet, and its approaches to managing conflicts of interest. This policy must be approved by the trustee’s board.6
- assess outsourcing options – the trustee must properly assess its outsourcing options. This assessment must include preparing a business plan for the outsourcing, undertaking a tender or other selection process, performing due diligence on the chosen service provider, and establishing a performance monitoring system. The trustee must be able to demonstrate this assessment to APRA.7
- evaluate risks of outsourcing – the trustee’s board must “identify, assess, manage, mitigate, and report” on the risks associated with the outsourcing, and have procedures to ensure the trustee’s business units understand and comply with its outsourcing policy.8
- document outsourcing arrangement in an Australian-law contract – the outsourcing arrangement must be contained in a “documented, legally binding agreement that is enforceable in Australia and is subject to Australian law”.9 This agreement must include a clause allowing APRA access to documentation and information related to the outsourcing agreement.10
- notify APRA before entering offshore outsourcing arrangement – all trustees must notify APRA within 20 business days of executing an outsourcing agreement. However, where a trustee proposes to outsource material business offshore, the trustee must consult with APRA before entering the agreement. APRA must then satisfy itself that the impact of the offshoring arrangement has been adequately addressed under the trustee’s risk management framework.11
Compliance may be problematic
It would be difficult, if not impossible, for an offshore private equity fund or hedge fund to comply with the requirement for the primary fund documents to be governed by Australian law. Granting APRA access to information may also be challenging.
If the Draft Standard is approved, these obligations will be binding on trustees from 1 July 2013.12
APRA is likely to register the Draft Standard in the Federal Register of Legislative Instruments before that date. If it does, some obligations will apply from the date of registration. Specifically, a trustee:
- entering into a new outsourcing arrangement on or after the registration date must comply with the standard’s documentation requirements (ie that the arrangement is documented, legally binding, enforceable in Australia and subject to Australian law, with a clause allowing APRA access to documentation and information about the arrangement); or
- with an existing outsourcing arrangement must:
- assess that arrangement against the documentation requirements;
- where possible, renegotiate the arrangement to minimise inconsistency between the arrangement and the standard;
- if the trustee determines renegotiation would not be in the best interests of beneficiaries, demonstrate to APRA why it considers the arrangement should continue; and
- report the anticipated end date of the arrangement to APRA.
We have again assumed that sponsors satisfy the SIS Act definition of “investment manager”. Even if sponsors are not investment managers for fund investments, some trustees might assess all performance fees on the same basis, whether charged directly by a traditional manager under a mandate or charged in a fund. In any case, sponsors are likely to be considered investment managers for any co-investments made by a trustee with a sponsor outside a fund.
There are many different ways that sponsors of hedge funds and private equity funds charge performance fees or receive a carried interest from the profits of the fund. But let’s concentrate on a familiar example, a private equity fund that has a 2% pa management fee on commitments, an 8% preferred return to investors and a 20% carried interest to the sponsor (with a 100% catch up). The 20% carried interest is calculated on a deal by deal basis and does not take into account the management fee or other expenses of operating the fund.
Under the Stronger Super regime, if a trustee arranges for an investment manager to invest assets attributable to the fund’s MySuper products (expected to be a substantial class of product by assets in the Australian superannuation system), the trustee must ensure the investment arrangements satisfy certain matters. One of those matters relates to performance-based fees.
A carried interest, being a share in partnership profits, does not neatly answer the description of a fee. Therefore, even if a general partner or sponsor is an “investment manager”, the carried interest earned might not be a performance fee. But let’s assume for the purposes of our exercise that the carried interest is a performance fee.
If the arrangement includes a performance fee, the trustee must ensure that:
- any “base fee” or retainer charged by the investment manager is lower than it would be if no performance fee were charged;13
- the period over which the performance fee is determined is appropriate to the type of investment to which the performance fee relates;14
- the performance of the investment is measured by comparison against the performance of investments of a similar kind;15
- the performance of the investment is determined on an after-costs basis (and after-tax, where possible);16 and
- the calculation of the performance fee includes disincentives for poorly performing investments.17
Review your fund terms
Whether these matters would be satisfied for any particular fund is a matter for the trustee making the investment to determine. It would be prudent for sponsors to begin considering their response to these matters now. Even if the Stronger Super measures do not apply, a trustee might choose as a matter of prudence to assess all its investments on a similar basis. Generally:
hedge and private equity funds are not measured by comparison against the performance of investments of a similar kind; and
carried interest is not often determined on an after-fees/costs or after-tax basis.
If trustees do decide to assess all their investments against these criteria, sponsors of hedge and private equity fund need to consider their response and whether they would countenance amendments to their fund terms.
What if those matters cannot be satisfied?
The draft explanatory memorandum has recognised that access to certain assets, such as those sold through international markets, may not comply with these requirements.18 Consequently, the Stronger Super regime allows a trustee to enter into an arrangement with an investment manager who charges a performance fee that is not in compliance with one or more of these requirements if the trustee can satisfy an overriding “best interests” test: that is, despite the arrangement’s non-compliance, it promotes the financial interests of fund beneficiaries who hold the MySuper product.19
If the trustee breaches a restriction and fails the best interests test, APRA may cancel the trustee’s authority to offer MySuper products for that fund.20
The takeaway is that the trustees “should only agree to an arrangement that is targeted to the objective of maximising the returns members receive”.21
Stronger Super represents a move by the government towards transparency, simplicity, and higher prudential standards in superannuation. If the changes are passed, sponsors of private equity funds and hedge funds will need to determine if those funds are going to embrace the changes, and adapt accordingly, or reject the changes, and potentially exclude Australian superannuation funds as investors in private equity and hedge funds.